Page 84 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

LOS 17.d: Describe other factors to READING 17: ANALYSIS OF FINANCIAL INSTITUTIONS
consider in analyzing a bank

MODULE 17.5: OTHER FACTORS

Government Support: Apart from providing deposit insurance, governments often serve as a backstop against bank failure. This is usually due to
the systemic importance of the banking sector. Implicit support level is inversely related to the overall health of the banking sector; during good
times, support levels are low.
Government Ownership: In some countries, absent government ownership, depositors may not have faith in the banking sector, a critical
element for a bank’s existence. Public ownership increases faith (of implicit government backing) in a bank.
Bank Mission: Apart from profit-making, banks may also pursue other objectives. If the community is dependent on a primary industry (e.g.,
banks in Houston, TX, had their fortunes tied to the oil industry in the 1980s), it may lead to concentration of risk in a community bank’s asset
portfolio. Global banks, on the other hand, have well-diversified asset bases, reducing their overall risk.

Culture: A bank’s culture influences its propensity to seek risky investments. Culture evaluation can be conducted by a review of:
• Diversity of a bank’s assets. Banks that have generated losses due to an investment strategy with a narrow focus may be too aggressive.
• Accounting restatements due to failures of internal controls pertaining to financial reporting. Restatements may indicate an unethical culture.
• Management compensation. Excessive compensation that is too closely tied to the performance of the bank’s stock may lead to a culture of
excessive risk-taking.
• Speed with which a bank adjusts its loan loss provisions relative to actual loss behavior. A slower response rate generally indicates aggressive
accounting practices and a risk-taking culture.

Generic factors:
• A competitive environment affects a bank’s culture and risk-taking behavior: a regional bank may be satisfied with its current market position and may not
be tempted to take excessive risk. Global banks may end up taking excessive risk as their management seeks to outdo their large rivals.
• Off-balance-sheet assets and/or liabilities may seriously affect an entity if the underlying risks turn out to be larger than the available resources. Often,
key information about a bank’s off-balance-sheet exposures may be opaque or not readily available to analysts, making it very difficult to examine.
However, all off-balance-sheet items are not equally nefarious. Operating leases, for example, are a lot less risky compared to selling protection in a
CDS. Bank analysts should look out for variable interest (or special purpose) entities, which are usually required to be consolidated. In some instances, if
an SPE is not deemed to be a VIE and therefore does not get consolidated, there may be a significant off-balance-sheet risk not reflected in the AFS.
• Segment information may provide insights into different lines of business or different geographical markets that the bank operates in. Each segment may
be exposed to different levels or types of risk, such as sensitivity to markets, geo-political risks, or cyclicality.
• Currency exposure is significant for large, global banks trading in currencies or holding significant assets or liabilities in different currencies whose values
fluctuate. Volatility in currency values can have a significant impact on a bank’s earnings.